These 4 Measures Indicate That Brimstone Investment (JSE:BRT) Is Using Debt In A Risky Way

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Brimstone Investment Corporation Limited (JSE:BRT) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Brimstone Investment

What Is Brimstone Investment's Debt?

You can click the graphic below for the historical numbers, but it shows that Brimstone Investment had R4.46b of debt in December 2020, down from R5.41b, one year before. However, it does have R1.36b in cash offsetting this, leading to net debt of about R3.10b.

A Look At Brimstone Investment's Liabilities

According to the last reported balance sheet, Brimstone Investment had liabilities of R2.20b due within 12 months, and liabilities of R4.39b due beyond 12 months. Offsetting this, it had R1.36b in cash and R836.4m in receivables that were due within 12 months. So its liabilities total R4.39b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the R1.79b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Brimstone Investment would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Brimstone Investment's debt to EBITDA ratio (4.1) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that Brimstone Investment saw its EBIT drop by 16% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Brimstone Investment will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Brimstone Investment created free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Brimstone Investment's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Brimstone Investment really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Brimstone Investment you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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